Multiple Choice (11 questions, 5 points each) 1. The New York Times reports that the toll on the Holland Tunnel was raised from $16 to $20. Following the toll increase, traffic fell by 5 percent. The chairman of the Port Authority (which operates the tunnel) audit committee warned that the toll increase could cause toll revenues to decrease by $48 million per year. Is this statement consistent with economic theory? (a) No, it is not consistent. Demand is elastic at the original price and thus revenues would increase if the toll were raised. (b) No, it is not consistent. Demand is inelastic at the original price and thus revenues would increase if the toll were raised. (c) No, it is not consistent. Demand for driving through the Holland Tunnel is perfectly inelastic and thus revenues would increase if the toll were raised. (d) Yes, it is consistent. Demand is elastic at the original price and thus revenues would decrease if the toll were raised. (e) Yes, it is consistent. Demand is inelastic at the original price and thus revenues would decrease if the toll were raised. SOLUTION: (b). The price went up by 25%. The quantity of traffic fell by 5%. So the estimate of the own-price elasticity is -0.2. This is inelastic. With inelastic demand, the increase in price should cause revenues to go up, as the fall in quantity is small relative to the price increase. 2/12 2. On September 14, 2017, the Wall Street Journal reported that “Swedish car-parts giant Autoliv, said it is considering splitting itself in two, separating its electronics operation from its business making safety devices like seat belts and air bags.” The article further quoted the CEO, Jan Carlson, as saying, “We believe it is time to let them both individually maximize their potential”. Wall Street initially seemed to agree as Autoliv’s stock was up 8.5% on the news. Based on this information, what does it appear that Autoliv believes is true about its business? (a) There are economies of scale in producing electronics and auto safety equipment (b) There are diseconomies of scale in producing electronics and auto safety equipment (c) There are economies of scope in producing electronics along with auto safety equipment (d) There are diseconomies of scope in producing electronics along with auto safety equipment (e) Both (b) and (c) SOLUTION: (d). The company is splitting into two divisions and estimating that each division will do better separately than they did as one combined entity. This is the definition of diseconomies of scope. The quotes given say nothing about the company producing more products leading to lower (or higher) average cost, so we know nothing about economies of scale. 3. (This question and the next both refer to the following setup.) The market for gyms & fitness centers in Ann Arbor is very competitive. While there are some differences between gyms, they are small and for most consumers every gym is exactly the same and they are willing to switch to whatever gym has the cheapest price. Let’s suppose that this market is initially in a long-run equilibrium. Then, the city government decides to impose a new annual licensing fee for all gyms, to help the city cover the cost of increased inspections and enforcement of safety regulations. This fee is an annual fee that all gyms have to pay and is the same for all gyms regardless of their size, how many clients they have, etc. Assume that nothing else about the gyms’ cost structure or about the market changes. Fill in the blanks: Compared to the initial long-run equilibrium, In the new short-run equilibrium, the price charged by gyms will and the profits of each existing gym will . (a) go up ; go up (b) go up ; go down (c) stay the same ; go up (d) stay the same ; go down (e) go down ; go down SOLUTION: (d). This change is the addition of a fixed cost for the gyms. That shifts up their average cost curve but does not change their marginal cost curve. Because marginal cost isn’t changing and the number of gyms isn’t changing in the short run, the market price won’t change. Because the price and MC haven’t changed, the quantity sold by each gym won’t change. However, fixed costs have increased so their profits will go down. Thus, in the short run, the answer is (d): the price will stay the same, but profits will go down.
